Monday, October 2, 2017

The Sum of All Fears.....and a few related charts......

Today, I'd like to take some time to revisit a couple of related topics that we first started discussing a few years ago. I am, of course, referring to the burgeoning increases in China's Debt levels, Shadow Bank Assets (loans) and M2, along with a high-level analysis of the most recent PBOC Financial Stability Report and FSB Global Shadow Bank Monitoring Report. (No!....please don't click this page closed....I promise this will eventually get interesting...)

As a starting point, let's begin by reviewing the February, 2015 McKinsey report Debt and (not much) Deleveraging. I first referenced the report in this blog in March of 2015. The report focused on the world's, and particularly China's, rapidly building debt/leverage phenomenon (2014 Year End Data). I encourage you to re-read the entire report, but for those of you who are pressed for time, I'll give you the executive summary bullet-points right here:

Debt continues to grow

Reducing government debt will require a wider range of solutions

Shadow banking has retreated, but non‑bank credit remains important

Households borrow more

China’s debt is rising rapidly

I'm hoping that the McKinsey authors will consider updating the report, bringing the figures current, as I believe these observations, figures and analysis are even more pertinent today than they were back in 2015.

China's Debt

So now, using McKinsey as a reference point, let's take a look at where we are today, via the FRED (St. Louis FED)data below.

Lets dig into the numbers. We see from 2006 thru 2016 US Core Debt increased modestly from roughly 220% of GDP to 250% of GDP. However, China's Core Debt, relative to GDPnearly doubled during the same period, to roughly 260% of GDP.

Before we discus the above, let's talk about what GDP is (and isn't). GDP is:

C+I+G+(NX) or:

(Consumption + Investment + Government Spending + (Exports-Imports)).

First, it's important to understand that increased GDP does not necessarily increase wealth or improve quality of life. A GDP calculation is measuring-stick for economic activity....nothing more. A GDP figure makes no representations as to the quality, efficiency or economic utility of the activity producing the GDP. i.e.) When my Dad was in the Army (WWII....the "big one") he talked about "practicing" digging fox holes. He and thousands of other soldiers would be told/ordered to dig holes and fill them in.....for no apparent reason other than to keep them busy. This activity, since he was being paid to do it, would increase GDP, even though it accomplished nothing more than wear the men out, keeping them out of the English pubs.

That said, here are a few examples of things that would significantly increase GDP.

Building a Superhighway, Bridge or Bullet Train connecting two uninhabited deserts or islands. (I+G)

Here are a few more you might not think about.....again, these are events/activities that increase GDP but don't necessarily increase wealth or quality of life.

A hurricane....all of the destruction has to be financed and rebuilt. (C+I+G)

Public Welfare and Housing Assistance Checks (C+G)

Single Payer Health Care (C+G)

Paying 10x as much for a medical procedure as you might pay in other countries (C)

So you get the point.....although it looks good on paper, incurring debt to build/finance things that aren't economically viable, produce little (or no) economic utility or fail to generate earnings and cash flow doesn't work too well over the long haul. At some point, the lenders won't be paid back.....or, as should happen in a free-floating world, if they are eventually paid back, they'll be paid back with a currency having a fraction of the purchasing power of the currency they initially loaned out to finance the activity.

China's "Productive GDP"

Now, let's get back to the bold Red line on the chart above and take some time to coin a phrase. We'll call it "Productive GDP" or PGDP. As any economist will tell you, desperate times call for desperate measures.....and new terminology! Let's say that China's "Productive" GDP, for lack of a better term, is defined as GDP excluding all of the over-building, non-productive excess capacity and accounting games created simply to hit the arbitrary 7%, etched in stone, silly, CCP mandated GDP growth target.

So let's further say that rather than the published, rock solid, 7%, annual NBS GDP growth rate, the "Productive", un-fudged, non-incentivized, PGDP growth rate is only 4.6%, (2/3rds of the published/reported rate), but still a remarkable number for an economy the size of China's. Extrapolating the bold Red Line above, if GDP is "overstated" by a third, we illustrate/conclude that the ratio of Core Debt to "Productive" PGDP explodes to nearly 400%, much higher than the current G20 average of 240%.

Author's Note: You math aficionados out there might be observing that the bold red line doesn't consider the compounding impact (i.e. reducing the GDP growth rate in a prior year impacts the current year starting point). So the method illustrated (multiplying GDP by a constant) actually overstates GDP. That's absolutely correct. However, since I have no actual data to base my adjustment on, it's a guess, an arbitrary adjustment, so the compounding doesn't matter. Besides using a constant was simply easier than trying to program the FRED model to compound the change. In any case, I'm just illustrating a point.

Keep in mind, the PBOC estimating Non-Bank Shadow loans is a bit like the local Sheriff estimating "unreported financial crime". He doesn't have authority over the mechanics of the activity, lacks enforcement resources and therefore can't do much about preventing the crime(s). Even if he had authority and resource, he'd have a hard time zeroing in on the metric....criminals generally don't respond to surveys or self-report their schemes. Moreover, the Sheriff would have an incentive to under-estimate the problem and hope everything works out, since, at some point, someone is going to be held accountable. As history shows, Chinese Bankers are well aware of the penalties for this type of chicanery. Financial scoundrels are normally exiled to horrific disgrace on a private tropical island with only occasional access to boatloads of Cayman Islands money. Their globe-trotting travel is restricted to other carefully selected, non-extradition, quasi-paradise jurisdictions.....and so it goes.

Again, based solely on the usual, limited transparency inherent in PBOC reporting (good things are trumpeted and bad things are swept under the rug), a disclosure like this would indicate that the problem is potentially much larger than they are letting on. In the 2017 Financial Stability Report (an oxymoron if I've ever heard one) the PBOC restates the Shadow Bank Assets for 2014 and 2015 (as shown by the dotted line in the chart below). To my knowledge, no other major economy has ever experienced an acceleration anywhere near these levels of Non-Bank, Shadow debt relative to GDP, much less restated it in a gigantic "ooppps....our bad" buried in a couple of paragraphs in the bowels of a report. In China....they do things big. The bigger the better. The two Charts below, prepared by Capital Economics illustrate that we've apparently entered uncharted waters.

Although the fiercely independent citizens, politicians and bankers of Hong Kong and Singapore might disagree, we can generalize that the leverage in those economies (tall bars on the left of the chart) is inextricably linked to the Chinese financial system. If there were ever a potential "ground-zero" for a default-induced financial contagion Shang-Hong-apore would be it.

Moreover, when we examine the PBOC/CE Charts above, it wouldn't be much of a reach to conclude that Shadow/Non-Bank Credit has become an absolutely essential tool for keeping all of the financial balls in the air. As reported by Ambrose Evans-Pritchard in a piece for the Telegraph:

Jahangir Aziz and Haibin Zhu from JP Morgan said the debts of the state-owned entities (SOEs) have alone reached 90pc of GDP or $13.3 trillion.

Nearly 60pc of new credit this year is being used to repay old loans. It takes four times as much new credit to generate a given amount of extra of GDP as it did a decade ago. “China’s rising indebtedness has come to represent all that is disconcerting about their economy,” they said in a report entitled “The Sum of All Fears”.Hmmmm....."The Sum of All Fears"....catchy little title for a financial/policy report! Tom Clancy would be proud....

"Total Social Financing" (TSF)Total Social Financing (TSF), yet another term of art the Chinese government introduced a few years ago to track the leverage in their economy, grew to RMB 155.99 trillion RMB (US$ 23 Trillion), up 12.8 percent from 2015, per the PBOC Report. (Pg. 28) The intent of this statistic is to track the "total financing" required by households and businesses. The process goes awry when we try to decipher exactly what's included in this metric and how the data is collected. There are numerous articles written on this topic and I've listed a few of them in the citations below. Suffice it to say that the consensus is, that a significant amount of Non-Bank Shadow financing is excluded from TSF. Interestingly, this metric, intended to show changes in the composition of how economic growth is financed, is potentially misleading, since significant Shadow risk is omitted from the calculations.

Some Verifiable Numbers.....BondsAs difficult as it is to measure China's fragmented Shadow Financial System, there are a few reported metrics which are presumably more reliable than others. China's bond markets are one such example. In the last two years (2015 & 2016) the value of new "Major" Chinese Bond issues (below) has actually exceeded the total amount outstanding of America's Corporate Bond market (about US$ 8.6 Trillion). Why is all of this new debt necessary? Again, most (60%?) of the new issues are used to roll over other bonds/debts/financing coming due.

Continuing the theme, Non-Performing Loans (NPL's) have somehow remained relatively constant, hovering just under 2% since 2011 as shown below. (pg. 44 of the PBOC Report)

How can this be? Perhaps it's just little old skeptical me, but usually, when borrowing skyrockets like this, underwriting is lax and bad loans go bad much quicker. The universally accepted game bankers play to keep a bad loan from being reported as non-performing is to refinance it and change the terms....and (drum roll please....) ....like magic, it's a performing loan again! In all likelihood, that's what's happening with this fake NPL statistic. It's hard to believe that China's financial system hasn't already broken its economic foot as a consequence of kicking all of these NPL cans down the road, but somehow it just keeps chugging merrily along. As my favorite Irish pub drinking song goes...."Roll me over in the clover.....roll me over lay me down and do it again...this is number one....we've only just begun....etc....etc...."A Few More Notes on the PBOC Financial Stability Report

The very existence of a recurring document entitled "Financial Stability Report" is disturbing. Does the PBOC really have to reaffirm the stability of their financial system every year? Moreover, it's a difficult read to say the least. The "don't worry, everything is under control" tone seems disingenuous and frankly, a bit over-done. When we do a quick word count we see that the word "stable" appears 49 times, "stability" 40 times and "improve/improving" 217 times. Conversely, "Deteriorated" was used twice and "Declined" was used 15 times, mostly in the context of "the occurrence of bad things declined a whole bunch". Predictably, "holy crap", "suck", "dumb ass" and "Armageddon" did not appear in the document at all.

In another odd twist, beginning on page 129 of the PBOC 2017 Financial Stability Report, there's a brief discussion on the methodology and findings of the FSB (Financial Stability Board)2016 Global Shadow Banking Monitoring Report, complete with what seems to be a veiled criticism of the US, EU & UK financial systems and the risk associated with each, generally concluding that "there's lots of risk out there, but everything is fine in China!". Here's a sample of the language from the report....please just indulge me for a moment:

Page 138 - PBOC ReportChina is now in
a period of economic structural adjustment and
upgrading alongside with structural conflicts,
so it is necessary to establish a financial
regulatory framework which fits for the
development of the modern financial market
and to enhance the role of macroprudential
policies. China thus continues to improve the
macroprudential policy framework, promote
the institutional arrangement of interagency corporation, enhance the monitoring and
identification of risks, and effectively
implement and calibrate policy tools, so as
to safeguard financial stability from all the
dimensions and throughout all the procedures,
and to hold on to the bottom line of allowing
no systemic risks to emerge.
Honestly, I'm not sure what the above even means, yet the entire report reads like this. It's actually painful. It makes my head hurt when I read it. Other than the typos (corporation vs. cooperation) and the improved, enhanced, structural framework-able, institutionalized, "bottom-line" overuse of a Thesaurus, the main criticism I have with the PBOC's critique of the FSB report is that they refused to participate. That's right, they spent ten (10) pages discussing the merits of a report, for which they declined to provide data.

While all participating jurisdictions are covered in the “macro-mapping” of jurisdictions’
financial system, data from China were not received in time to complete an assessment of
entities in China for the narrow measure of shadow banking. Improvements to Chinese data
collection are currently underway in order to enable Chinese authorities to fully contribute to
the 2017 monitoring exercise.A disclosure like this absolutely requires that we deploy our patented, Dick Fuld Bankerspeak Translator (BST) to figure out what the hell the FSB is saying. Here's the translation:

"Holy shit.....we invite you guys to participate in our risk study, for the common good of all of our participants, and dare we say, all mankind, and you give us a bunch of outdated, nonsensical macro data? When we ask you for the detailed-narrow, supporting data, which would help explain what's going on for our peer review, you take your ball and go home? You're the 'second biggest economy' on the planet and you can't hit a deadline?....and then.... just a year later.....after reporting this top-side bull-shit .....you have the cajones to add another US$24 Trillion to the number you gave us? What's next? an airplane hanger full of gold bullion and diamonds was missed?... Really? Do you guys have any clue at all re: what's going on with your financial system?"

Here's a Chart showing the breakdown of Other Financial Intermediaries (OFI) by Jurisdiction, including some of the (pre-revision) macro data provided by the Chinese government (Pg. 17):

The size of Other Financial Intermediaries (OFIs) is measured by the sum of assets of all financial corporations that are not classified as central banks, banks, insurance corporations, pension funds, public financial institutions, or financial auxiliaries. 2015 Global OFI assets, prior to China's restatement for 2015 and 2016 was reported at US$ 92 Trillion. If we're to apply the PBOC 2016 restatement, adding the "newly discovered" US$ 24 Trillion of OFI Assets to the total, all else being equal, we see that OFI Assets increase to US$ 116 Trillion, of which China's OFI Assets are actually US$32 Trillion (28%) rather than previously reported US$ 8 Trillion (8%) of OFI Assets.

Note that assets invested in foreign jurisdictions may distort these ratios. International Financial Centers like (IE) Ireland (Tech/Apple Money), (HK) Hong Kong, (SG) Singapore, (CH) Switzerland, etc. where the worlds multi-nationals, elites and assorted nefarious criminals/cartels tend to park their money, distort the ratios. e.g.) These countries inherently have huge financial systems relative to GDP because they are holding "someone else's" money. Further, data for the Cayman Islands are not represented in the above graph – the size of
the Cayman's financial system was around 200,000% of GDP (US$ 6 Trillion) at end-2015, thanks to their extremely....hmmm....how do I put this kindly/professionally.... "friendly" banking system. Moreover, there's no public data, at least that I'm aware of, describing the composition of any of the "off-shore" money by nation/jurisdiction. Specifically, for our analysis today, it would be particularly important to know how much of this money is actually "parked" Chinese shell company money (Alibaba, Tencent, etc.).....but I digress.

The simple formula:

CN+HK+SG+KY = OUCH

Shang-Hong-apore + Caymans = Opaque Unacceptable Contagion Hegemony

Based on the above we see that the size of China's Financial System, including Shadow Banking, is just over 400% of GDP as of 2015, prior to the PBOC Financial Stability Report Shadow Banking revisions. Now, again, all else remaining constant, let's superimpose both the PBOC Shadow Banking revisions and the above described "Productive" PGDP adjustment on the data...and see what we get....

Pretty ugly....don't you think? Again, the leverage in the Chinese financial system per dollar of GDP is more than twice that of the US and most developed, non-financial center jurisdictions. I'd imagine that these skyrocketing, continuously revised ratios are scaring the living snot out of every Economist on the planet by now. But you and I will never know what hit us. Economists, and highly compensated Investment Bankers, as we all know, have nerves of steel.....as long as there are big fees involved.

Of course, there's been volumes of commentary on the agency decisions. Predictably, the Chinese Ministry of finance vehemently disagrees with the downgrade(s). The comments from the analysts re: the downgrade are generally benign ......steady as she goes.....everything will be fine...the government will bail everyone out, etc. One of the few, powerful exceptions of note, at least that I could locate, came from Claire Dissaux from Millenium Global Investments - who said: "China’s credit problem is the biggest problem we have ever seen in any country....etc......all that is an argument to say China’s rating might still be too good.”"

Dump-Trucks full of Money

As expected, when debt grows like this, the money supply must grow as well. Chicken?...egg?...etc. As we can see below (per FRED), China's M2 isn't only growing, it's exploding. Again, in China, nothing is written off. Every business is a success...usually the biggest, best, greatest in the world. Nothing ever fails. Nothing defaults. Every "can" is dutifully kicked down the road. When a debt can't be serviced, it's viewed as a short term problem and it's rolled over into new debt or some sort of hybrid debt/equity/securitized/investment product by some entity other than a bank. Of course, you need dump-trucks full of money (M2) to accomplish this magic.

Per the above, we note that US M2 has ballooned, nearly doubling since 2006. The FED has been on the greatest globally-fueled, money-printing, expansionist, binge in US financial history. Yet, Janet Yellen looks absolutely hawkish when we compare US Monetary Policy to the PBOC. China's M2 has increased more than 500% (similar to the combined Core/Shadow debt levels) during the same time period. Remarkably, the RMB has simultaneously strengthened. I've long opined about the impossibility of this relationship if it wasn't for China's dual On-Shore/Off-Shore currency system, yet this theoretically impossible relationship continues to exist today. The RMB could actually be the greatest, government-manufactured bubble in financial history.

What's Next?

China Bulls would tell you that the meteoric growth in the Chinese financial system, and satellites (Hong Kong, Singapore & the Caymans) is actually appropriate based on the size of the economy. They would tell you that China is an unstoppable juggernaut. Based on the PBOC revised numbers, compared to a theoretical "Productive" PGDP, I couldn't disagree more. The hard landing that so many have predicted has now become unavoidable. It's just a matter of time. The math doesn't work... and it never will.

On the other hand, this financial party has been going on for quite a while now, perhaps much longer than many of us would have thought possible. Yet, when we examine the evolution and underlying changes in the global financial landscape, we can also conclude that this condition can indeed continue on, perhaps indefinitely. I addressed this phenomenon in my The Theory of Financial Relativity post last year. If Central Banks all provide liquidity in lockstep, at the same relative rate, bubbles can indeed go on forever. This "new normal", if to be believed, would make the world a much safer place to invest. Bubble-ized asset prices and currencies would be supported in perpetuity. Investors would be in a no-lose situation. Our task would be effectively reduced to "picking the best bubble" from a universe of bubbles!

Unfortunately, the risk of course is that, at some point, for some reason, a Central Banker or two will refuse to play ball and the whole thing will unravel. Bubbles will burst. As fate would have it, we're starting to get tepid rumblings of tighter money from some of the players. Both the FED and Bank of England have signaled tightening. The FED will begin "balance sheet normalization" (selling bonds) and the BOE is considering raising rates.

The ramifications of what would seem to be subtle policy shifts, knocking things "out of balance", will be devastating to the global financial ecosystem.

7 comments:

But China will have switched completely to EVs by 2030 thus replacing the global automobile supply chain with their own domestic EV technology and production. Add to this the inevitable dominance of their domestic aircraft industry, the billions now being spent on oil refineries AND the OBOR initiative and you will see that China's increase in money supply will be well justified.

The rest of the world will be only employed with industries that China no longer wants anymore like plastic toys and garments and China will have reached its final form in which they can finally pay back their debt.

As sarcastic as I was in my previous comment, I do worry about the continued outflow of subsidized Chinese goods into the global trading system. A large part of the surplus comes from suppressed wages, financial repression through the banking system, etc. Much of which can't be addressed under the current system.

Since the current account must equal the capital account, the heart of the imbalance lies in China's ability to accumulate foreign reserves via a trade surplus. I can't imagine the CCP letting the domestic debt bubble pop until they're absolutely forced to do so through trade intervention by other countries in particular the US.

Alternatively, it could be yet another accounting scheme....(e.g. Baba Pictures or Baba Health)......take control....then spin off an IPO at a later date at manipulated/fake prices.........booking a gain and permanently writing up and "locking the value in amber" of the remaining interest on their balance sheet .....while the newly spun off Cainiao stock tanks.....right out of the BABA playbook......just sayin'

Here's a movie I think everyone that reads this blog will enjoy. It's done by the same guy who did "The Smartest Guys in the Room" about Enron. This one is about China and Alibaba. Thankfully we know all this stuff already due to Deep Throat :-)

About Me

I prefer to post anonymously, at least for now. I currently own an Insurance Agency, am a former CPA, Auditor & CFO. I've received Graduate and Undergraduate degrees in Accounting and Finance from the University of Wisconsin (Go Badgers!) and generally have a wonderful, charmed life. This blog is purely entertainment for me since I enjoy discussing business, trends, equity valuations, accounting "techniques" and the general silliness of IPOs lately. I am interested in evaluating "odd" security issues with "you gotta be kidding me" filings, so if you have something interesting, or you'd like me to take a look at a filing, feel free to let me know. Of course if I ever have a position in any of the securities I'm discussing (doubtful) it will be disclosed prominently at the top of the post.